Enhanced tax deduction for research & development expenditures

The Inland Revenue (Amendment) (No. 7) Ordinance 2018 enacted on 2 November 2018 provides enhanced tax deduction for expenditures on qualifying research & development (R&D) activities. Following the enactment of the new law, Departmental Interpretation and Practice Note (DIPN) No. 55 was issued by the Inland Revenue Department in April 2019. The new deduction effects retrospectively to expenditure incurred on or after 1 April 2018.

The amended section 16B allows taxpayers a generous 300% deduction for “Type B expenditure” on the first HK$2 million spent on a qualifying R&D activity and a 200% deduction on expenditure after the first HK$2 million, with no cap on the deductible amount – subject to certain conditions. Details are set out in Schedule 45 of the Inland Revenue Ordinance (Cap. 112).

To qualify for the deduction of Type B expenditure, it must be R&D expenditures arising from a qualifying R&D activity and related to the trade, profession or business of the taxpayer.

R&D activity

Section 2 of Schedule 45 stipulates that an R&D activity is:

(a)   an activity in the fields of natural or applied science to extend knowledge;

(b)  a systematic, investigative or experimental activity carried on for the purposes of any feasibility study or in relation to any market, business or management research;

(c)   an original and planned investigation carried on with the prospect of gaining new scientific or technical knowledge and understanding; or

(d)  the application of research findings or other knowledge to a plan or design for producing or introducing new or substantially improved materials, devices, products, processes, systems or services before they are commercially produced or used.

Qualifying R&D activity

Section 4(1) of Schedule 45 further defines a qualifying R&D activity as one falling within the description in section 2(a), (c) or (d) of Schedule 45 (above) and which is wholly undertaken and carried on in Hong Kong.

Section 4(2) of Schedule 45 also sets out the following exclusions:

(a)   any efficiency survey, feasibility study, management study, market research or sales promotion;

(b)  the application of any publicly available research findings or other knowledge to a plan or design, with an anticipated outcome and without any scientific or technological uncertainty;

(c)   an activity that does not seek to directly contribute to achieving an advance in science or technology by resolving scientific or technological uncertainty; or

(d)  any work to develop the non-scientific or non-technological aspect of a new or substantially improved material, device, product, process, system or service.

Paragraph 12 of DIPN No. 55 highlights that the exclusions are made with due regard to those adopted in other tax jurisdictions with similar tax incentives (e.g. the United Kingdom).

R&D expenditures

Section 6(1) of Schedule 45 specifies that an R&D expenditure, in relation to a trade, profession or business in respect of which a person is chargeable to profits tax, is:

(a)   a payment to an R&D institution for an R&D activity related to the trade, profession or business;

(b)   a payment to an R&D institution which has, as an object, the undertaking of an R&D activity related to the class of trade, profession or business to which the trade, profession or business belongs, where the payment is used for pursuing that object; or

(c)   any other expenditure on an R&D activity related to the trade, profession or business, including capital expenditure except to the extent that it is expenditure on land or buildings or on alterations, additions or extensions to buildings.

R&D expenditure excludes payments or expenditures for acquiring rights generated from an R&D activity (Section 6(2) of Schedule 45). The expenditure for acquisition of patented rights can however be allowable under section 16E of the ordinance.

Section 6(5) of Schedule 45 defines an R&D institution as a designated local research institution, or a university or college that is not a designated local research institution. Under section 19 of Schedule 45, the Commissioner for Innovation & Technology may designate any of the following institutions as a designated local research institution:

(a)   any university or college located in Hong Kong;

(b)   any other institute, association, organization or corporation located in Hong Kong that undertakes qualifying R&D activities in Hong Kong.

Type B expenditure

Section 10(1)(a) and Section 12(1) of Schedule 45 set out the meaning of a Type B expenditure, in relation to a trade, profession or business in respect of which a person is chargeable to tax as “for a payment made, or other expenditure incurred, on or after the commencement date – an R&D expenditure falling within any of the following descriptions:

(a)    a payment to a designated local research institution for a qualifying R&D activity related to the trade, profession or business;

(b)    a payment to a designated local research institution which has, as an object, the undertaking of a qualifying R&D activity related to the class of trade, profession or business to which the trade, profession or business belongs, where the payment is used for pursuing that object; or

(c)    a qualifying expenditure related to the trade, profession or business which is:

• an expenditure in relation to an employee who is engaged directly and actively in a qualifying R&D activity; or
  
• an expenditure on a consumable item that is used directly in a qualifying R&D activity.

Deemed trading receipts

Certain proceeds from sale of plant or machinery used for an R&D activity or of the rights generated from an R&D activity (in connection with a deduction claim under section 16B) are deemed as trading receipts chargeable to profits tax.

Royalty or other income of similar nature in connection with a deduction claim under section 16B may also be deemed to be trading receipts:

(a)   sums for the use, or the right to the use, outside Hong Kong of any intellectual property or know-how generated from any R&D activity in respect of which a deduction is allowable under section 16B in ascertaining profits of the person under profits tax; or

(b)   sums for imparting or undertaking to impart knowledge directly or indirectly connected with the use outside Hong Kong of any such property or know-how.

Seeking advice from the commissioner for innovation & technology

Upon receiving a claim or an application for an advance ruling in relation to a deduction under section 16B, section 18(2) of Schedule 45 provides that the Commissioner of Inland Revenue may consult with the Commissioner for Innovation & Technology (I&T), or a public officer authorized by the Commissioner for I&T, to ascertain:

(a)   whether an activity constitutes an R&D activity or a qualifying R&D activity; and

(b)   whether an R&D expenditure was incurred, or is to be incurred, by the claimant or applicant in relation to an R&D activity or a qualifying R&D activity.

In relation to this, the secrecy provision in section 4 of the ordinance has also been amended so that information or documents could be passed to the Commissioner for I&T, or  the authorized public officer.

General anti-avoidance rovisions (Sections 61 and 61A)

Although the Commissioner of the Inland Revenue will generally act in accordance with DIPN No. 55 in processing deduction claims for R&D expenditures, in cases where tax avoidance is involved or the R&D deduction regime is abused to secure a result which is not intended under the amendment ordinance, the Commissioner will consider invoking the general anti-avoidance provisions under section 61 and/or 61A of the ordinance as appropriate to counteract the tax benefit which would otherwise be obtained (Paragraph 116 of DIPN No. 55).

Conclusion

It is not an easy task to apply the above set out in the ordinance. In particular, enquires about qualification of research and development expenditures for tax deduction are not uncommon. To address these enquires, DIPN No. 55 has provided a list of examples to further illustrate the applications and implementations of its principles and provisions. Readers are encouraged to make reference to that in their application.

·      Cap. 112 Inland Revenue Ordinance ─ Schedule 45

·      Departmental Interpretation and Practices Note (DIPN) No. 55 issued in April 2019

·      Inland Revenue (Amendment) (No. 7) Ordinance 2018 enacted on 2 November 2018

·      Inland Revenue Ordinance (Cap. 112)─ Sections 4, 61 and 61A

About the authors

Dr. Annie Mok Yuet-ngo - PhD, FCPA(HK), AICPA (full member), CPA (Washington State, USA), AHKTI, CTA, Department of Accountancy, Instructor, City University of Hong Kong.

Dr. Olivia Leung - PhD, CPA (British Columbia, Canada), Faculty of Business and Economics, Assistant Dean (UG), Principal Lecturer, The University of Hong Kong